How to Create Your Own Target-Date Mutual Fund

This is a guest post from Frank Curmudgeon, who writes about bad money advice at his aptly-named blog, Bad Money Advice.

You may have heard of target-date funds. In 2006 they were okayed as default investment options for 401k accounts, so if you said nothing about where you wanted your 401k money to go, you might even have found yourself the proud owner of one.

A target-date fund is a mutual fund that is made up of other mutual funds. It’s sort of an all-in-one solution that contains a variety of fund types in an attempt to create a diversified portfolio that could serve as all the investing a person needs. Each target fund has a year in the future associated with it, intended as an approximation of the investor’s planned retirement date. So a target fund dated 2015 would be more conservatively invested than one dated 2040.

Are they a good idea for you? Well, target-date funds are not terrible. They make reasonable default options, but you can probably do much better. To understand what might make them less than ideal, consider the following.

The trouble with target-date funds
Imagine that your local supermarket, in order to reduce the stress and confusion of shopping, started a new service: Target Shopping. Instead of having to push a cart through the aisles and make purchase decisions on your own, now all you need to do is hand your money over to an expert Target Shopping Specialist. This expert will select, based only on the ages of the members of your family, the ideal mix of groceries for you and have them put in the trunk of your car. As a consumer, would you think this is a good idea? Now suppose you were the store manager. Would this be a good business?

I don’t think anybody would want to have somebody else pick their groceries based on demographic information about their family. But I bet the store manager would think this idea was just totally awesome. Even if he didn’t charge anything for this “service” beyond the normal price of the groceries involved, being able to decide what the customers bought would be super convenient. He could make sure they bought the high profit items and stayed away from the loss-leaders. If there was too much of an item one week, the Target Shoppers could take it off the store’s hands. And, of course, they would never get anything that was on sale.

There are two problems here:

The person selecting the products is unlikely to get it right, even if perfectly honest, because they know so little about the customer.

They have lots of incentive not to be perfectly honest.

From the point of view of a consumer/investor, target-date funds have basically the same problems. You are asking a company to make a decision about the risk you are willing to take based on only one tiny bit of information about you: the year in which you hope to retire. Further, that company has a significant conflict of interest, because when they pick your investments they are also deciding how much profit they are going to make.

Even within a single company’s mutual fund offerings, the fees that funds charge — and the profits they make for the company — can vary a great deal. As a general rule, the more risky the fund the higher the fee, so stock funds have higher fees than bond funds, growth stock funds that invest in small companies have higher fees than value funds that invest in big stodgy ones, and so on. As a result, the more risk the target fund manager decides you should take, the more money they make. Are you comfortable with that?

And there is a conflict of interest even without considering fees. Like any business, mutual fund companies have some products that sell well and some that sell poorly. There will always be the temptation to load up the target fund with the stuff nobody else wants.

By way of illustration, let’s take a quick peek under the hood of one of the biggest target-date fund families, Fidelity. (The other two big players are T. Rowe Price and Vanguard. Together the three are 80% of the business.) I hope to retire around 2035, so we’ll start there. Fidelity’s Freedom 2035 Fund is about 80% in stocks and 20% in bonds. That’s a little more exciting than I would like. (But it turns out that both T. Rowe Price and Vanguard are even riskier, at around 90% stocks.)

There are a total of 25 funds in the Freedom 2035 portfolio. Fidelity’s largest (most popular) fund, the Contrafund, is not on the list. Nor is the Spartan 500 Index Fund, known for its tiny annual fee of only 0.07%. Overall, Fidelity charges 0.77% for the target fund. That’s actually not bad; the average for 2035 target funds is 1.30%.

How to create your own target-date fund
For people who don’t know much about investing, target-date funds have a lot of appeal. You hand your money over to an expert and then don’t have to worry about it until retirement. But you can do better. Here’s a simple method to create your own target-date fund that will take only an hour or two of your time.

Find your adjusted target date. Start with when you actually expect to retire. Then, to counteract the natural tendency of fund companies to skew things to the risky, deduct 15 years from that number. If you are a risk-averse person, knock off another five years. If you are the courageous type, add five years. (And if you are not sure if you are more or less comfortable with risk than the average person, try taking this quiz.)

Bootleg your allocation percentages. Go to the websites of two or three target fund vendors (e.g. Fidelity, T. Rowe Price, and/or Vanguard) and, using your adjusted target date, find out what percentages those companies’ target funds are using for stocks, bonds, and cash. (If you wanted to get fancy, you could go further and break it down to U.S. stocks, international stocks, government bonds, corporate bonds, etc., but I don’t think this is really necessary.) A nice thing about target funds is that they are required to publicly disclose how they are invested. Average the percentages you find to make your own set.

Roll your own. Take the stock percentage of your investment savings and put it in a low-cost index fund, such as Fidelity’s Spartan 500. Put the bond portion in a low cost bond fund, such as Vanguard’s Total Bond Market Index Fund. Put cash in a money market fund. Your average fees should be less than 0.20%.

Once a year, rebalance. As the prices of the funds change, the percentages of your portfolio that they represent will drift away from the targets you set. Once a year, sell a little bit of the one that is too big and buy some of the one that is too small to get them back where they should be percentage-wise.

Once every five years, repeat steps 2 and 3. As you get closer to retirement, you may want to get more conservative in your investments. But you may not want to bother with this step at all if you are under forty, as the percentages probably won’t change much.

This is not a perfect system (nothing is) and I can think of several ways to make it much more complicated and a little more effective. But as it is, it will give better results than investing in a target fund, for a very small expenditure in effort.

One possible roadblock is if your investments are inside a 401k plan, which limits your fund choices. If your plan does not include appropriate bond and stock funds to use for your allocations, but does have target funds, you might consider investing in a target fund using your adjusted retirement date rather than your true one.

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Frank’s approach is the most sensible for those who want to minimize costs and maintain a consistent allocation. Target Date funds which contain actively managed funds are subject to manager style drift, regardless of what Fidelity says the asset allocation is, you have no way to know if that’s accurate or not at any given time.

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cappy

Frank,

I have no idea how you equate asset allocation funds to grocery shopping – not a good analogy. How a mutual fund could toss in loss leaders is beyond me. If the fund stinks, no one buys it. Unless you can take the time necessary to educate yourself and really keep up, a well-run asset allocation or lifecycle fund can keep you at least somewhat on track. Just pick a year closer to now to stay conservative and leave the tweaking and balancing to those who do it for a living.

The Spartan 500 Index fund hasn’t exactly protected anyone lately. It’s down 37% over the past year. And Vanguard Total Bond is flat. A lot of the retirement allocation funds did better than that.

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Roger

Frank,

Interesting guest post. Although, I think your grocery store illustration is a bit off the mark. As you noted in the second step of your instructions, fund families are required to publish the holdings in their target date funds, as well as how those allocations change over time. If our hypothetical grocery store had to the same thing, publish all the groceries that are purchased under its Target Shopping program, then families who think the grocery mix is inappropriate could opt to choose their own groceries (or find another store with more appropriate Target Shopping). Or, if the mix is only slightly different than what they would choose, they could put part of their money towards Target Shopping, and use the rest for individual groceries to reach their desired mix.

Similarly, investors can view the allocation of the target date funds, and could (a) use them if the allocations are appropriate for their needs and goals, (b) avoid them and ‘roll their own’, getting their desired asset mix (and possibly cutting down their expenses at the same time), or (c) compromise: put part of their money in a target date fund and use the rest to buy other mutual funds to reach their desired allocations. Which way is best depends on the individual investor.

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Willie

Jeezz. You guys must take a chill-pill (or two)

Of course you can TRY to beat the market. I missed one word in my reply, one word: “try”. (that will teach me to read before submit)…

I guess you couldn’t pick up on that while reading my total reply? To happy to jump all over me??

Listen, I believe as much in index funds and/or target-date funds as you do, because you are correct, the vast majority of so called professional fund managers fail to beat the market, so what makes us believe we can?

I don’t consider myself an experienced investor at all, that’s why I invest mostly in index-funds (and some target-end-date).

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wanzman

Willy says (#26)

“OF COURSE you can beat the index funds, IF you have all the time, knoh-how and desire to do so.”

Right. That is why the vast majority of professional mutual fund managers fail to do this on a consistent basis (I can’t really think of any that do it on a consistent basis, to be honest)…and incur significant fees and fund turnover in the process.

But Willy on the other hand, must be a genious. Willy, which fund do you manage?

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John

Mark,

You must be just reading what you like to see.

Read carefully and post a normal reply please.

Nobody here on this blog listed that claim you refer to…. Mood point…

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Mark

JF and Willy-

How are you backing up your claim that Actively Managed Funds do better than Index Funds. The research that I have seen does not support this.

If you are looking for some extremely intelligent, expert advice on index funds and their advantage over Actively Managed Funds, I suggest you take a few minutes to read some of the entries on the bogleheads.org forum.

“Novice or inexperienced investors…” HA!

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AmericanCliche

I think target-date funds are great for people starting out or far away from retirement. Tweaking isn’t necessary when you’re 40 years away from retirement; at 24 I believe a 90% allocation in stocks isn’t an option, it’s a necessity!

Target date funds are good for society. If people buy these funds because they’re easy to manage more people will save for retirement. The more that save for retirement, the fewer our children will have to support via government hand outs.

Finally, I’d like to see someone who managed their own portfolio and didn’t incur a loss. Stocks, bonds and gold were down in 2008; money market accounts broke the buck! So I don’t see it as a bad thing if a 2010 target date fund lost 20% compared to the performance of most index funds.

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Willy

The problem is that index-funds are not designed for the people who read these kind of blogs, and spend time replying to them… They are for a more novice or inexperienced investor..

OF COURSE you can beat the index funds, IF you have all the time, knoh-how and desire to do so.

Truth is, there are tons of hard working Americans who simply don’t understand the system. For them, an index fund is a good instrument to secure future retirement income with low fee’s and acceptable returns.

Mark I think that depends on your approach. If you’re a passive sort like me, it’s just a question of asset class allocation and which brokerage you happen to like the best.

I don’t try to pick the best performers, I try to pick the instrument that I feel indexes the category more or less with the lowest cost and most reliable least expensive brokerage.

I know some people aren’t going to agree with that thinking and that’s okay, and I can see how it’d be a lot harder if you were trying to beat the market consistently.

I think these things have a place though. Lots and lots of people just do not want to even learn at all how this stuff works. It’s sad. They are better off with a product like this since they’d throw it all in a hole left on their own.

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Mark

I do not believe it is “just as easy”. You have to research all the funds, re-balance yourself, and you must have enough cash to start all the funds.

Doesn’t sound “just as easy” to me!

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DDFD at DivorcedDadFrugalDad

Nice post!

This targeted approach is the latest passive investing gimmick the financial service providers are pushing . . .

You can just as easly do it yourself as you laid out.

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JF

Buy and hold is dead. Please stop advocating it as a viable strategy. People MUST learn to actively manage their investments based on economic events or they will not make money from this point forward.

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Snowballer

I invest in one at present. But I very carefully checked its allocation and made sure it’s what I’d do anyway, or pretty close to it anyhow.

It’s something to do with your money when your retirement savings are small like mine are so buying multiple funds is tricky, yet you seek instant diversity.

If I can ever get my portfolio to grow much, I will eventually trade into the component funds and rebalance it myself annually.

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Jorge

This is an interesting post and I always prefer the do-it-yourself approach whenever I know enough to do it properly.

One of the best reasons to do your own allocations, which you did not mention, is that you likely have your retirement assets spread out among several accounts. Between 401k’s, his and hers IRA’s and other accounts from multiple jobs, most families have several retirement accounts which makes using a target date fund difficult. Each account also likely has different funds available to it.

In order to properly allocate your assets among the various asset classes, many people will have to create their own target date fund by adding up all of their accounts and figuring out where they have their money invested. Then once a year they should relook at their allocations and figure out which funds in which accounts to sell/buy in order to stay on track to their target allocations.

I enjoyed the article – thanks!

-Jorge

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Aleks

We had target date funds as the default option for our company pension plan, and the main reason I opted out of it wasn’t the fees or the lack of control, it was the fact that I don’t expect to stick with the same fund company until I retire. I’ve been at basically the same job for 10 years, however in that time I’ve been laid off, re-hired and had the company I work for bought out. On top of that, we’ve just plain changed fund managers twice. So in 10 years at the same job I’ve had my company RRSP/pension contributions change four times. Each time I’ve dumped the accumulated money into my personal RRSP.

So while I’m still young and have an aggressive mix in my personal retirement savings, I want a more conservative mix in my pension plan because I do not expect that the money put there will stay in the same fund until I retire. My investment timeframe is much shorter than my retirement timeframe.

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Joe Light

@Tim

I’m not sure what you mean by a “let it ride” approach in Target-Date funds. The managers of target-date funds automatically rebalance the portfolio for you…some of them rebalance every day. As far as the benefits of regular rebalancing goes…basically what a target-date fund is supposed to do is manage your risk level. So if you’re in the 2010 fund the portfolio is supposed to be conservative enough that you won’t lose money quickly (or make it quickly for that matter). Most of them do this by overweighting older people’s portfolios with bonds and younger people’s portfolios with stocks.

If someone who retires next year had allocated 80% to stocks and 20% to bonds himself 20 years ago when that might have made sense, and rode the market until 2007 without rebalancing at all or adjusting his weighting, he’d have had the overwhelming majority of his money in stocks right before the market crashed. If he had instead rebalanced along the way, he would have still done pretty miserably, but at least wouldn’t have his portfolio cut in half in 2007 and 2008.

Now I also have a problem with target-date funds, and it’s mainly because they apparently don’t work in mitigating older peoples’ risk. I’m not saying they’re a bad idea in theory, and they’re certainly better than not investing or never rebalancing yourself. But just look at the results! The Vanguard 2010 fund was down 21% in 2008. The Fidelity Freedom 2010 fund was down 25%. Sure, it would have been even worse if the soon-to-be retirees didn’t have any rebalancing done for them and had a whole lot of money in stocks, but to me, it feels like a 25% loss in one year is too much.

@Will Crowthers

I know a few financial planners who rebalance once their clients’ portfolios get out of whack by a certain percentage, such as 5%. So if a client is supposed to have 70% in stocks, and the market drops so that he only has 65% in stocks, he’ll sell bonds and buy stocks for him. (and the the other way around). I think rebalancing in that way makes sense when the market is volatile as long as you’re dealing with tax deferred accounts and won’t face tax implications for selling.

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Keith

One thing I didn’t really feel was covered in this article is how to ‘REMEMBER’ to repeat the steps as necessary. Since this isn’t auto-magical like a managed Target-Date fund, I would recommend setting up some sort of reminder service (Google Calendar, anyone?) so you don’t neglect to do this. Anyone have any ‘investment reminder’ tools that would be better? I’d be great if it would notify you when a new prospectus comes out or some other sort of news that might affect your investing decisions came out. I get some of that stuff from my broker, but not all of it.

Agree with much of what has been said already. I have the Vanguard TR2020 fund, but will not retire until 2030. I bought TR2020 because I looked at the allocation and it fit my goal better. Now I can get into 5 quality index funds for only $3K. Costs are low and re-balancing is done for me.

What is wrong with that?

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SaveBuyLive

I took one look at the target retirement fund that was offered in my 401 and noticed that the expense ratio (somewhere around 0.77%) was significantly higher than any of the funds that composed the target.

After that I decided to make my own target retirement fund. I’m glad that I’m not the only person out there trying this strategy.

But to be fair, a target fund is better than no fund.

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Will Crowthers

Frank,

Great information – really enjoyed it. I had a couple of questions:

1. Regarding re-balancing is 1 year really enough? In years like we are currently in would re-balancing once/month be more beneficial?

2. With re-balancing one of my biggest challenges has been managing this and finding an easy tool for these calculations. Do you have any suggestions?

Thank you so much for this. I’m actually putting together my first retirement plan right now and am having to decide between a target-date fund or choosing the funds on my own. Given my limited experience I was leaning toward the target-date fund, but now I think I’ll just do more research on the individual options.

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Tim

I’d have to echo the thoughts and criticisms of this article by Matt. I like these target retirement funds for the simple reason that they take a lot of the hassle and rebalancing work out of investing over the long haul. Perhaps someone smarter than me can explain why me rebalancing my portfolio from year to year is smarter than a “let it ride” approach with these types of funds. I would think this type of adjustment (“tweaking”) could lead to some gains, only to be offset by losses from time to time for the majority of us who aren’t financial experts. In my mind, the “tweakers” may not come out much better than the “let it ride” crowd (or so I’ve read). What do others think?

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Matt

JD,

I’ve always loved your site, but this is a bad article, even though your tip on how to create your own target fund is correct.

Your grocery analogy is simply wrong, since the criticism you level against a target fund is the same criticism to be made against ALL mutual funds: they MIGHT invest in sectors you don’t care about, and they MIGHT try to make excessive profit. By your analogy, the only real way to avoid this is invest in individual stocks, something you don’t typically advocate.

Besides, most mutual funds have SOME percentage of assets in other funds, so it’s not as though you can avoid this problem completely.

There are good reasons to balance your own assets, but your reasoning is simply a poor reason to avoid mutual funds.

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ObliviousInvestor

Alex is correct: Vanguard’s Target Retirement Funds do not charge an extra level of expenses.

That said, many other fund companies do. Be sure to read the prospectus to find out before investing in one.

Him (#8) brings up a good point as well–target retirement funds allow you to diversify in a way that would not be possible with small amounts of assets.

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Him

The problem with this strategy is that one needs a high amount of cash to invest in some of the “cheaper” funds. The Fidelity Spartan 500 has a *minimum* initial investment of $10,000; the Vanguard Total Bond Index Fund requires a minimum initial investment of $3000.

The target date funds allow people just starting out a great way to diversify their money without having to have a large amount of cash.

We’re currently heavily invested in target date retirement funds, but when we get enough cash (if the market ever decided to pay nicely) we’ll be doing our own asset allocation.

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Alex

I cannot speak for all investment managers but I know for certain that Vanguard does NOT charge anything incremental for target-date funds (you only pay fees on the underlying assets).

Source: Vanguard founder John Bogle makes this fact a bragging point in his book “Enough”.

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Kevin M

I think we can all agree that someone who buys a Target Date fund is probably a novice investor looking for something quick, easy and relatively painless to invest in. That being said there are several problems with this option as discussed in the blog:

1) fund minimums – I have assets with Vanguard and most of their funds have a $3k minimum. That means you’d need at least $15k to start assuming comment #2 is correct.

2) Are there really “loss leaders” and high margin items in the mutual fund world? Especially when discussing Vanguard or Fidelity if you stick with index funds – which is mostly what Target funds are made up of – you should always have <1% expenses.

3) For the “adjusted target date” – why not just pick a different existing target date fund based on your risk tolerance and review the holdings every 5 years?

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Rob

Correct me if I’m wrong… but doesn’t an investor have to pay the 0.18% for the target date fund AND the individual fees of the funds that make up the target date fund? After comparing the percentage of each fund holding and its expense ratio, I found the average for the individual funds was 0.18%. So does an investor actually pay 0.36% (0.18 from the actual target date fund and 0.18 from the individual funds making up the TDF)?

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Stephen

What is the longest you can realistically set as the termination date for one of these?

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ObliviousInvestor

I absolutely agree that target retirement funds aren’t perfect. (Five Cent Nickel also had a post about the drawbacks recently.)

And your idea of an indexed portfolio that’s annually rebalanced is a summary of exactly what I’d suggest for most people.

That said, I really do think that target retirement funds are an excellent choice for many investors due to their zero-ongoing-work factor. (Though admittedly, people should check out the glide path to make sure the asset allocation at each point is roughly in line with their own ideal allocation.)

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wanzman

Perhaps the author should have done further research. Citing the expenses and holdings of ONE SINGLE MUTUAL FUND is hardly evidence enough against target date funds.

It is hard to listen to someone who cannot do a full 2 minutes of research before writing an article such a this.

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Writer’s Coin

I like what you’re saying here—especially the idea of just ripping off their “menus” and creating your own funds at a fraction of the cost.

But I think the grocery-store analogy is flawed. Everyone shops for groceries—it’s something we can all do. But investing and picking out percentages and funds is not. People do NOT like to do this stuff. They’d rather do a little bit of work once and forget about it, even if it means paying a little bit more.

We put my wife into a Target date fund with Vanguard, and I think it’s perfect for her. It has a 0.18% expense ratio and all the funds it contains are great Vanguard funds.

As to your problem about wanting to be more conservative, just buy a fund that is set to “retire” earlier and the bond allocation will be greater.

I say all this with a sly smile of my face because I wish I wrote this post—but I do think they are a very useful, valuable product for a lot of people.

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